Institutionalization of the hedge fund investor base has shifted the
profitability ratios of the industry, Citi notes. Profits derived from
management fee revenues now equal profits from performance fee revenues
in years like 2013 when managers meet institutional targets of 10%
annual returns.

Citi’s report, formerly known as the Hedge Fund Business Expense
Benchmark Survey, is based on proprietary analysis and detailed
responses from 149 hedge fund firms that collectively represent $581
billion in industry AUM - 19.8% of total industry assets. The title of
the survey has been changed to reflect a broader focus on industry
margins, profitability and valuations rather than on detailed expense
benchmarks.

“Management fee revenues have become an increasingly important part of
the industry’s profit base in recent years,” said Sandy Kaul, Global
Head of Business Advisory Services at Citi. “Lower institutional return
targets and concerns about excessive volatility make it more difficult
for managers to earn outsized performance fees. With AUM at record
highs, profits from management fee revenues now account for a larger
share of total profits, coming in at nearly 2.5 times performance fee
profits in years when performance is down such as in 2014.”

Importance of Hedge Fund Profits to Overall Asset Management Industry

Tracking hedge fund profitability is critical due to the outsized
influence these firms exert on the asset management industry’s total
profit pool. Using Boston Consulting Group’s (BCG) industry-wide
estimates to frame their findings, Citi calculates that in 2013, hedge
funds’ $31.2 billion in profits accounted for 34% of BCG’s $93 billion
forecast on total asset management industry profits versus only 4% of
BCG’s $68.7 billion estimate on total asset management industry AUM.

The most notable change in hedge fund operating margins in 2014 was a 17
basis point improvement in operating margins for small hedge funds with
average AUM of $100 million and individual fund AUM of between $0 and
$350 million. Despite this improvement, Citi reports that firms in this
band are still unable to cover their operating costs based solely on
their management fee collections. In 2013, they posted an operating
deficit of 86 basis points, but in 2014 that shortfall fell to only 69
basis points. This helped push break even for these firms looking to
cover costs from management fee income down from $330 million in 2013 to
only $310 million in 2014, Citi notes.

“Poor performance will be most acutely felt by small hedge fund firms,”
Kaul explains. “These organizations were able to use their performance
fee profits in 2013 to cover their management fee operating shortfalls,
but as a group, these funds simply did not generate enough performance
fee revenues in 2014 to cover their gap. We see a $615 million
industry-wide shortfall across this tier of firms and this is likely to
result in more closures of small hedge funds.”

Theoretical Value of Hedge Fund Industry Down Only 7%

While poor performance cost the hedge fund industry 30% in profitability
in 2014, this factor only resulted in a 7% drop in the theoretical
equity value of the industry, Citi reports. This difference is explained
by Citi using industry experts’ approach of counting profits from
management fees at 4 times the value of profits from performance fees in
their model. Citi puts the total theoretical equity value of the hedge
fund industry at $239 billion in 2014, down from $257 billion in 2013.

The diversity of a firm’s product mix and investor base are key factors
that affect how large a multiple to use for management company fee
profits in valuation calculations, Citi reports. This is leading to
greater product expansion across the largest hedge fund firms, they
note. Survey respondents in Citi’s $10 billion AUM tier had 83% of their
assets in their core hedge fund product but those in their $10 billion
AUM tier with average AUM of $31 billion had only 35% of their assets in
that category and by contrast had 36% of their assets in publicly traded
long only or liquid alternative assets.

“For large hedge fund firms, having a mix of privately traded and
publicly traded funds helps support higher firm valuations in all our
scenarios except when hedge fund performance is at 10% or better,” Kaul
concludes.

Citi, the leading global bank, has approximately 200 million customer
accounts and does business in more than 160 countries and jurisdictions.
Citi provides consumers, corporations, governments and institutions with
a broad range of financial products and services, including consumer
banking and credit, corporate and investment banking, securities
brokerage, transaction services, and wealth management.

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